Interest Rate Roundup

Tuesday, June 24, 2008

Food for thought on the big picture and inflation ahead of the Fed

Everyone is paying close attention to this week's Federal Reserve policy meeting. The majority of the commentary I've read has been focused on the minutiae -- whether the Fed will "talk tough" and/or imply that it's ready to implement one or two quarter-point rate hikes later this year.

But what about the big picture? Is the Fed truly ready to “fight inflation?" Would one or two minor rate increases make a difference? Well, consider this ...

The nominal federal funds rate is currently 2%. But the Consumer Price Index is rising at a 4.2% year-over-year rate. That means REAL, inflation-adjusted interest rates are NEGATIVE 2.2%. Money isn’t just cheap. It isn’t just free. It’s BETTER than free. In fact, rates haven’t been this deep into negative territory since 1980!

That’s not all. Since the beginning of 1980, the real funds rate has averaged POSITIVE 2.4%. Just to get real interest rates back to "normal" (and assuming the inflation rate remains constant), the Fed would have to hike the nominal funds rate all the way up to 6.6%!

Forget the debate over the language in the Fed's post-meeting statement, or whether the Fed will push through a 25-basis point hike or two later this year. Instead, think about this: The Fed would have to more than TRIPLE the nominal funds rate to get the real funds rate back in line with its historical mean.

Now we all know that's just not going to happen. In fact, I doubt the Fed will hike at all tomorrow. But as the chart above makes painfully clear, the Fed has kept the real funds rates in negative territory for a considerable portion of the past few years. The last time the Fed did the same thing was a period stretching from the mid-1970s through 1980. What was the result? Stagflation. Food for thought the next time you wonder why oil prices are at $136+, food prices are going through the roof, and overall inflation is on the rise.


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